3 Reasons To Underweight High-Yield Debt

November 11, 2014

Sure, high yield looks cheap these days, but that’s no reason to overweight it.

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article is by Larry Whistler, president and chief investment officer of Buffalo, New York-based Nottingham Advisors.

Thanks to the combination of strong returns over the past five years in the high-yield space and the continued suppression of short-term interest rates by the Federal Reserve, investor demand for subinvestment-grade bonds remains strong. Although the high-yield bond market has cheapened up some over the past six months, we remain cautious and continue to underweight the sector in our portfolios.

Our move from overweight high yield to neutral-to-underweight is based on three primary factors:

  1. The current risk premium for high yield debt is near its all-time low
  2. The quality of junk bonds continues to deteriorate
  3. Investor awareness of the potential for sell-offs in the space is low

To be clear, we still do own positions in some of the market’s biggest and most-liquid junk bond ETFs—such as the SPDR Barclay’s High Yield Bond ETF (JNK | B-68)—in our Global Income strategy, but we take a much more cautionary position relative to high-yield debt at this juncture.

So, let’s examine Nottingham’s circumspect attitude more closely.

Still Worth The Risk?

In June of this year, the BAML US High Yield Index reached its lowest spread over Treasurys since the financial crisis began. Since that time, the risk premium that investors receive over default-free Treasury securities has increased by nearly 100 basis points.

Still, at about +450 bps, the risk premium that investors are receiving is nearly 150 bps less than the average over the past 20 years for bearing the default risks associated with the high-yield debt market.

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